Last August, in a column titled "When Housing and Monetary Policy Collide," I discussed the historical importance of the California housing market as an indicator of the future trajectory of housing in other urban centers. With the Fed meeting today, this is a good time to review and update what's happening in the California housing market and what it implies about the economy and housing on a national basis.
I'll skip discussing the homebuilders as a group because I just did so last week. But I will reiterate that I am still of the opinion that the environment for the homebuilders is not as strong as their stock prices are indicating, and it is especially weak for the builders of higher-end residential single-family dwellings, with Toll Brothers (TOL) most at risk of a downturn in that segment. The change in home prices in Southern California has been impressive over the past few years, with most markets regaining half to two-thirds of what was lost between 2007 and 2011.
However, the real annual rate of growth in California house prices has been decelerating throughout this year from the bubble trajectory of 2012 and 2013 that was driven by cash buyers, both foreign and domestic. Those price increases were exacerbated by a mismatch between supply and demand that was largely caused by the banks not foreclosing on nonperforming mortgages.
The rate of appreciation caused by these events has also now caused cash buyers to withdraw from the market. The reduction in mortgage rates over the past year, however, has not caused leveraged buyers to move back in and replace the demand that was withdrawn by the cash buyers. What's disturbing about this as well is that it has occurred simultaneously with a substantial loosening of underwriting guidelines for jumbo loans as mortgage lenders have been searching for a replacement for the lack of demand for homes by first-time buyers.
The historical precedent for real median house prices in California is for the cumulative real change of prices to decline to near zero or negative in the next four to seven years. If the historical precedent repeats, it implies a decline in real prices of between 28% and 40%, depending on location, with a nominal decline of between 20% and 30% from peak to trough.
If, however, the trend rate of the consumer price index continues to decelerate and the historical precedent is maintained, the nominal decline will be even larger. Put another way, homes purchased over the past two or three years with less than a 20% to 30% down payment will be back into a negative equity position with the balance of the first trust purchase mortgage being greater than the resale value of the home, even before transaction costs are considered.
This also represents a substantial problem for the mortgage lenders, as they will have to tighten loan-underwriting guidelines for jumbo loans, which will reduce their revenue and earnings. It is probable that this process will start very soon. The company most affected by this will be Wells Fargo (WFC) because it has been by far the most aggressive in the jumbo residential mortgage space and mortgage lending and servicing in general is by far the biggest part of its business. JPMorgan Chase (JPM) has also been aggressive in pursuing the jumbo loan space, but not nearly as much as Wells Fargo.
Both companies are also the dominant wholesalers of mortgage capital to the rest of the mortgage origination companies and set underwriting guidelines for the industry as a result. Although all of the builders and money centers are up today following the release of the Fed's statement, the housing action in Southern California, which traditionally leads the rest of the country, suggests that headwinds are continuing to mount.